As investors, we're trying to buy assets at prices that will generate an attractive return. A return made up of interest, dividends and capital gains. It sounds simple enough, but there's plenty of things preventing us from making sound, rational decisions.
There's the challenge of assessing, prioritizing and assimilating the unrelenting flow of news on currencies, interest rates, economic growth and companies. There's central bank pronouncements, takeovers and new products. And, of course, elections.
There are also some powerful factors that have a recurring and predictable influence on what investors hold, and I would suggest they lead to suboptimal portfolios. Call it undue influence.
Whether it's a mutual fund or ETF, there's no getting around the psychological impact of recent results. Investors' perception of how good or bad a fund is is shaped by how it's done lately. Portfolio managers who are putting up good numbers look and sound smarter than the rest. Funds that are doing well receive glowing reviews.
I put recent history in the undue influence category because short-term returns (one to two years) are as close to random as you can get. They have not predictive value. Any number of economic, political and environmental factors can influence how a fund does in the short term.
Medium-term returns (three to five years) are more insightful, but even they can be heavily influenced by one or two underlying trends in the market (resources, interest rates, growth versus value).
To assess a fund or manager, you need to look at results that cover a full market cycle (10 years is a good proxy) and consider other factors such as people, philosophy and process.
A stock market index is like a vacuum. It sucks portfolios toward it. Investment managers always know how they're positioned relative to the index and are even pressured sometimes to closely mirror it.
An extreme example of this is Valeant Pharmaceuticals International Inc. Do you think so many funds would have owned Valeant if it hadn't become such a big part of the S&P/TSX composite index (it was the most valuable stock in Canada for a heartbeat in 2015)?
There were many aspects of the company that didn't fit managers' criteria, but the stock was hard to ignore because it was single-handedly carrying the index higher.
The index influence reveals itself in fund managers' language. Their two most commonly used words are "overweight" and "underweight."
In Canada, a manager doesn't own 5 per cent positions in three bank stocks. Rather, she is underweighted banks – i.e. they make up less of her portfolio in percentage terms than the S&P/TSX composite index. A vacuum indeed.
"Tom, I don't know that much about the company, but it's got a nice 6 per cent divvie."
We all want nice dividends, which is why they too wield undue influence.
Dividends are the portion of profits that is distributed to shareholders. But a stock's yield is not a measure of value. A company's ability to generate these profits in the future is what determines its worth.
At Steadyhand, like many managers, we look for companies with growing dividends. We love them. But our decisions on which ones to own are not based on yield, but rather an estimate of the underlying value of the business.
Canadian investors are a skittish lot. In general, they've been seriously underinvested in stocks over the past cycle, often holding large amounts of cash. It comes from the fact that the tech wreck (2001-02) and financial crisis (2008-09) came in rapid succession.
Those who have stepped up to invest have gravitated toward guaranteed products and ones that claim to offer equity-like returns with low volatility. But while "low vol" has intuitive appeal, you shouldn't sacrifice upside or diversification to achieve it. The best way to control volatility is not with an individual stock or fund, but by holding a broadly diversified portfolio. Asset mix is the biggest lever you have in controlling volatility.
How can you deal with these undue influences?
Diversify on a broad range of factors, not just what's done well lately or is a big part of the index. Buy dividend stocks because they're attractively priced, not because they have the highest yield. And assess your managers on what you're asking them to do – generate long-term returns.
Tom Bradley is president of Steadyhand Investment Funds Inc.